Understanding asset classes

One of the main reasons South Africans don’t invest – apart from not having enough savings – is a lack of basic education on what investment choices are out there and what each one can do. This can act as a huge barrier to a wealthier, more successful future. In a bid to overcome this barrier, I would like to introduce the basic asset classes, unpack how they produce returns and explain how investors can best benefit from each type.

Let’s start with a look at the most well-known asset class – equities. Simply put, asset classes are a grouping of similar types of investments which are accessible to the investing public. The most fundamental asset classes are equities, bonds, listed property and cash (money market instruments).

What are equity assets?

Also known as stocks or shares, equities represent a share of ownership in a company that you can buy. Unit trust managers generally invest only in companies listed on the stock market, which means that the company is publicly owned and its share price is published daily. Besides providing transparency, this makes it easily tradeable.

What determines the share price?

The share price depends on many factors: one of the fundamental drivers is the rate of profit growth produced by the company every year. Supply and demand on the stock market drive the share price on a daily basis, influenced by news, rumour and market sentiment. Shareholders make gains or losses depending on the price movement after having bought the share.

What are the benefits of investing in equity?

Equities around the world have historically produced the highest returns for investors over time, rewarding those who stay invested over the long term, meaning seven years and longer. In addition to the growth your investment can achieve as the share price rises, companies may pay dividends to shareholders, which represent a portion of the annual profit of the company. Dividends are generally paid every six months and can represent a steady income for investors.

How risky are they?

Equities are considered the most risky asset class because share prices are subject to large movements in the stock market on a daily basis, so that as an investor you can experience large gains or losses. This is referred to as “volatility”, or the degree of movement over time. The higher the volatility of a stock, or any asset, the higher its risk.

How do equity unit trust investments behave?

Unit trusts that invest only in equities are higher risk than those that invest in other assets. Their prices move further and the chance of loss is higher. Volatility (and risk) decreases over time, however – the longer you stay invested in equities, the less risky they are, since the chance of loss is reduced over time.

What does this mean for investors?

Equity investors need to have a longer-term investment horizon of about seven years or more, in order to fully benefit from their equity holdings. They should therefore have a longer-term investment goal – like retirement – and be willing to ride out the ups and downs of the equity markets, ignoring the short-term news flow. Those who switch in and out of the market frequently have been shown to earn lower returns over time.

What are bonds?

When you buy a bond issued by a government or company, you are lending money to that entity so it can raise funds to finance spending. It is therefore a form of loan. Bonds issued by governments are called government bonds, sovereign bonds or gilts. When a government spends more on health, education, infrastructure etc. than it receives in taxes, it needs to borrow the difference by issuing bonds.

Bonds issued by companies are called corporate or credit bonds. Bondholders lend money in return for regular interest payments plus a final repayment after a certain period (typically one year or more). Government bonds and many corporate bonds are listed and traded on public exchanges, so they are priced daily and can be bought and sold by investors easily.

What are the benefits of investing in bonds?

Because investors earn interest as a regular income (usually paid out quarterly), individuals who require a high level of income, plus medium- to long-term capital appreciation with relatively low risk, would benefit from investing in bonds or in unit trust funds that hold bonds. Inflation-linked bonds are distinguished by the fact that the interest rate they pay is linked to the prevailing inflation rate, and adjusts as that rate moves up or down. These bonds therefore provide investors with some degree of protection against rising inflation.

How do bond prices move and how risky are they?

Bonds are generally affected by changes in interest rates. Their price falls as interest rates rise, because the fixed interest rate they pay becomes lower, and therefore less attractive, than the latest rates offered for an equivalent risk level. The opposite is true with a fall in interest rates: when the central bank cuts rates, the existing fixed interest rate paid by the bond becomes more attractive compared to any new bonds issued, and the price therefore rises.

What is listed property?

Property companies, like those that develop and manage properties (or real estate) of various types, and are listed on a stock market, generally comprise the asset class known as “listed property”. Two of the biggest in South Africa are Growthpoint Properties and Redefine Properties. This asset class gives investors exposure to various types of property including industrial, office, commercial and residential space. There are over 40 property unit trusts, loan stocks and REITs (real estate investment trusts) listed on the Johannesburg Stock Exchange. They offer the benefits of real estate ownership without the problems of being a landlord, and unlike physical real estate, these shares can be quickly and easily traded.

How does listed property earn returns?

Because it is an equity, a share in a listed property company produces returns through the rise or fall in its share price over time, resulting in capital gains or losses. Additionally, it offers an income in the form of regular shareholder distributions of the rental income the companies earn (often linked to inflation).

How does it differ from other equities?

Because listed property distributions are generally based on rental incomes that rise over time, the distributions are usually more reliable over time than other listed companies. This difference generally makes listed property stocks less risky than other equities, since their distributions are likely to be steadier. This gives listed property the characteristics of both equities and bonds, making it a good diversifier. This is the primary reason why listed property is considered a separate asset class to other equities.

What type of investor would it suit?

Because you’re investing in a portion of a portfolio of properties rather than a single building, you face less financial risk. Individuals with a medium- to high-risk tolerance requiring medium- to long-term capital and income growth would benefit from listed property investments. The recommended investment horizon is five years or longer.

What protections are in place with listed property?

A Real Estate Investment Trust (REIT) is a type of listed property company that is governed by strict regulations in terms of its structure and operations. South Africa’s REIT regulations are very similar to those in other countries, helping underpin investor confidence. For example, REITs are required to pay out at least 75% of their distributable profits to shareholders.

Before SA REIT legislation was implemented, there were two forms of listed property entities in South Africa: property loan stocks companies (PLSs) and property unit trusts (PUTs). Most have adopted the REIT regulatory framework set out by the Johannesburg Stock Exchange (JSE).

What are “cash” investments?

Cash assets comprise a range of securities that basically take the form of short-term loans which pay regular interest, usually with a repayment period of less than a year. These securities can comprise of various types of money market instruments like certificates of deposit, bankers’ assurances, promissory notes and company commercial paper. The terms “cash” and money market” instruments are often used interchangeably.

How do they differ from other interest-bearing securities like bonds?

Given their short maturity period, the interest paid – and therefore the return to investors – is generally lower than bonds. However, they are also lower risk than bonds because of their shorter repayment period. Money market securities are among the lowest-risk investments held by unit trust funds other than physical cash (bank notes).

Asset managers buy a mix of money market securities issued by various companies, banks and government borrowers, with various maturities up to 12 months, to be held in their money market unit trusts and multi-asset unit trusts for their diversification benefits. Funds are priced daily and interest accrues daily. There are no charges to deposit funds or to redeem funds.

What are the benefits?

Not all investments are made with long-term growth in mind. At times you need your money to be easily accessible, yet safe, which makes a money market unit trust a suitable option. Not only do they offer better returns than the interest paid by a bank account, generally keeping up with inflation, but money market unit trusts are also more flexible than term deposits offered by banks – there is no fixed waiting period before withdrawing your money (like 90 or 180 days). This could suit you if you are saving money towards a down payment on a home or new car, or have a baby on the way.

What type of investor would it suit?

Money market funds are ideal if you are looking for a “parking facility” for your cash. They also make suitable “emergency” funds for unexpected expenses that arise. The recommended investment horizon is one to 12 months.

[1] Source: Prudential Investment Managers